LEVERAGED BUYOUTS

An LBO is the acquisition of a target through the employment of a vast portion of

debt, typically from 60% to 70%, while the remainder is covered by the equity
contribution of the financial sponsor. The target repays its new debt with its strong
power of cash flow generation, as well as guaranteeing with its asset base. The
larger the debt portion, the higher the returns for the sponsor (who seeks to maximize
the IRR of the investment, usually around 20+%) and the bigger the tax shield effect.
1) Key Participants
Financial Sponsors The term refers to traditional private equity firms,
merchant banking divisions of investment banks, hedge funds, venture capital funds,
and special purpose acquisition companies (SPACs), among others1. For the sponsors
there are some limitations on the investments to be done (e.g., no more than the 10-
20% of the capital under management can be invested in one individual transaction).
Some sponsors focus on specific sectors, others on specific situations, or can even be
generalist sponsors. Before the formal offer for an LBO transaction, the sponsor
performs accurate due diligences on the target, supported by financial advisors,
consulting firms, and accountants.
Investment Banks They have a fundamental role in LBOs, on the sell-
side as M&A advisors (and possibly as stapled financing providers) and on the buy-
side as advisors (sharing their expertise, relationships, and in-house resources) and
financiers. It is on the buy-side in particular that their role of providers of financing
requires the most attention, with in-depth due diligences to be performed to assess
the target’s business plan and capability to repay debt. In case of positive results from
their analyses, investments banks agree the financing structure with the sponsor and,
after the approval of the internal committee, ensure the financial commitment to the
client for the bid. This commitment is testified by a commitment letter2 that lists the
settled terms and conditions, the possible caps and flexibilities in financial
instruments, certain required limitations (e.g., a minimum sponsor’s equity
contribution and level of EBITDA for the target) but also fees and roles for the
investment bank. Thus, the arranger(s) will have in its (their) loan portfolio the
revolving facility provided to the sponsor, as well as the term loans, up to a certain
amount (the remainder will be syndicated, at least in the intention, to other financial
institutions). As an underwriter, moreover, the IB tries to collocate the debt
1
PE firms, hedge funds and venture capitals employ resources collected from other investors and organized into funds
generally structured as limited partnerships. This means that general partners oversee the day-to-day management of the
fund, while limited partners serve as passive investors. This results in major fee charges for LPs: management fees (1-
2% per annum on committed funds) and carried interest (the sponsor receives a 20% carry on every dollar of profit in
excess of the invested capital and return threshold required).
2
The commitment letter is typically the first of three documents: commitment letter to guarantee the availability of bank
debt and bridge financing in case of illiquid capital markets; engagement letter, with the investment bank engaging to
underwrite bonds on behalf of the issuer; fee letter, specifying the remuneration of the IB.
instruments issued by the sponsor on the market and, in case of impossibility,
guarantees the access to a bridge facility.
Bank and Institutional Lenders Bank lenders provide revolvers and
amortizing term loans and to this category belong commercial banks, savings and
loan institutions, finance companies, and the IBs serving as arrangers. Institutional
lenders provide longer term financing and limited amortization term loans and to this
category belong hedge funds, pension funds, mutual funds, insurance companies, and
structured vehicles such as CDOs funds. As in the case of IBs, before providing debt
capital such actors conduct an accurate due diligence3 on the credit merit and
business plan of the target; in case, they may require covenants and collaterals to
actually lend resources to the target in order to mitigate downside risk. Part of the due
diligence is the “bank meeting” settled by the lead arranger during which the senior
management of the target presents to potential lenders the business and the
investment merit of the company, also providing them with additional information in
a Q&A session and distributing an hard copy of the presentation and a Confidential
Information Memorandum (CIM).
Bond Investors Generally institutional investors, they attend one-to-one
meetings with the target’s management in the so called “roadshow presentations”.
Roadshows last from three to five days and bankers from the lead arranger
accompany the target’s seniors on meetings with potential investors. The potential
investors, before the presentations, receive an initial Offer Memorandum which
contains detailed info on the company and its financials, risk factors, and features of
the debt instruments issued (i.e., a preliminary term sheet excluding price, that still
has to be established, and a description of notes). Once the roadshow is concluded,
the bonds can be priced and the final OM can be distributed.
Target Management and MBO The management itself is fundamental
for a successful LBO, as it is the primary face of the company for the investors and
must support adequately the bankers in their advisory. Therefore, during such
transactions, managers may perceive high returns through stock options and
“rolling” their current share in the post-LBO company. Sometimes, however, they
can be the actual sponsors, together with an equity partner, of an LBO on the
company they manage, in a so called Management Leveraged Buyout (MBO)4.
2) Characteristics of a Strong LBO Candidate
Usually, LBO targets are chosen among non-core or underperforming divisions of
larger companies, troubled companies with turnaround potential, sponsor-owned
3
Usually, they may rely heavily on the due diligence already performed by the arrangers.
4
Reasons behind an LBO may include: the management thinking it can run the company more successfully on its own;
the will to become a private company, as to avoid SEC and SOX compliance requirements as well as for efficiency
matters; in case of the acquisition of a division/subsidiary of the company, the idea of an improved efficiency in an
individual management.
businesses held for an extended period, or companies in a fragmented market as
platforms for a roll-up strategy5. In other cases, the target is just a solid company with
a strong competitive position. In case of public targets, the preferred ones are those
undervalued by the market with growth opportunity yet to be exploited.
Strong Cash Flow Generation It is fundamental given the levered financing
structure. Cash flow must not only be secure, but also predictable, and the
assumptions for the projected period must be sensitized coherently with the historical
volatility and potential future market/economic environments.
Leading and Defensible Market Positions This generally reflects strong customer
relation, brand name recognition, superior services, a favourable cost structure, and
scale efficiency, among other attributes. This features usually represent barriers to
entry.
Growth Opportunities Both organically and through bolt-on acquisitions6, in
order to increase the cash flow available for debt repayment, improve profitability
and operating income, and most importantly to obtain “multiple expansion”. In this
perspective, sometimes sponsors lower the leverage burdening the financing structure
as to allow future debt increases, supporting growth opportunities.
Efficiency Enhancement Opportunities This means, opportunities to cut costs or
to improve operational efficiency7. These opportunities are typically assessed by the
consultants hired by the acquirer.
Low Capex Requirements This feature, enhancing the target’s cash flow
generation, increases its value, all else being equal. If high capex is required to
express at full the target’s expected growth, it can be evaluated positively by the
sponsor. Anyway, if economic conditions and/or operating performance decline, the
growth capex8 can be widely reduced.
Strong Asset Base Particularly relevant in the leveraged loan market,
where it is correlated to the amount of debt available as well as to the rates to be
paid to the lenders. It may also be considered an indicator of strong barriers to
entry. The quality of the asset base increases with its liquidity.

5
Roll-up strategy refers to a consolidation of multiple companies and divisions in a given industry as to increase scale
and scope efficiency.
6
Bolt-on acquisition refers to the acquisition of smaller companies, usually in the same line of business, that presents
strategic value. This is in contrast to primary acquisitions of other companies which are generally in different industries,
require larger investments, or are of similar size to the acquiring company.
7
Such as, but not limited to, reducing corporate overhead, streamlining operations, introducing lean manufacturing and
Six Sigma processes (focused on dropping waste of production and improving output quality reducing product
variability, respectively), reducing headcount, rationalizing supply chain, implementing new management information
systems.
8
As opposed to the maintenance capex, it is the expenditure the exceeds that necessary to sustain existing assets.
Proven Management Team Management that has already experienced running a
high-leveraged company or has participated to restructuring activities adds relevant
value to the company and increases the probability of a successful LBO. Otherwise, if
the management does not give the required guarantees to the sponsor, it can decide to
replace it post-transaction.
3) Economics of LBOs
Typically, the expected IRR for such operations is attested around 20+%, depending
on the financial context. The primary drivers are the projected financial performance,
purchase price, the exit multiple and year and the financing structure. Another useful
indicator is the cash return, that is to say the multiple of the cash investment
obtained with (expected from) the exit.
An LBO can generate returns by two means (read the example in Appendix A):
first, the cash flow generation can be employed to pay interests and reimburse debt,
thus increasing the equity percentage of the company value and incrementing share
price; otherwise, the cash flow can be employed to pay interests and the remainder
reinvested in the business, thus enhancing growth and, consequently, valuation.
Another instrument employed to maximize returns for the acquirer is the leverage
level. Increasing leverage increases the tax shield effect, on one side, while on the
other, being debt a fixed amount, the assumed same growth in absolute value of the
EV has a larger percentual impact if on a smaller number of shares, thus creating
higher returns. For further explanation, read the example in Appendix B. Obviously,
in reality a too high leverage indicator is accompanied by a higher risk, thus a
substantial increase in the cost of debt and decrease in the availability of lenders, also
making the company less flexible and more exposed to market downturns.

4) Primary Monetization Strategies

Typically, exit occurs within a five-year horizon as to provide LPs with timely
returns. In exceptional cases, the investment period can be shortened
(extraperformance) or prolonged.
Sale of Business The typical exit strategy, historically, is the sale to a
strategic buyer, because of its ability to realize sinergies and thus offer an higher
price. Recently, however, the number of PE firms and the availability of capitals on
the markets have increased the component of financial sponsors as possible acquirers.
Initial Public Offering Other typical strategy, selling part of the owned shares to
the market. This allows the sponsor to benefit from a liquid market in case it wants
to sell its remaining stake, share the possible upside potential, and, in some cases,
obtaining a relevant premium on the share value.
Dividend Recapitalization This strategy implies the issuance of additional debt9
as to pay shareholders a return before the actual exit. The advantage of this
methodology is that, despite the dimension of the dividends paid, the sponsor keeps
its entire stake in the target.
Below Par Debt Repurchase In many occasions, the sponsor can buy on the market
debt instruments issued by its portfolio companies at distressed levels, thus below
par. This means that, once the market reconsiders the growth opportunities and cash
flow generation of the company, the value of the issuances increases accordingly.
5) LBO Financing: Primary Sources
Bank debt, also referred to as “senior secured credit facilities”, is typically composed
of a revolving credit facility and one or more term loans. It is a form of private
debt, although it ties borrowers to covenants. The cost of bank debt is usually
indicated as a rate that increases a benchmark (e.g., LIBOR) of a spread relative to
the credit merit of the borrower10.
Revolving Credit Facility Availability of a certain amount of credit for a
specified period of time, in respect of the terms expressed in the credit agreement.
Credit can be used and restored during the availability period, as well as reborrowed
after its closure. The instrument requires a low rate (slightly below term loans) and
an annual commitment fee on the undrawn portion of the revolver. On the other hand,
lien on certain assets and compliance with certain covenants are required.
Asset Based Lending Facility It is a type of revolver for current asset-intensive
businesses, as the facility is secured by first lien on all current assets and sometimes
second lien on all the other assets. The borrowing base is defined by:
Borrowing Base=85 % Eligible Accounts Receivable +60 % Eligible Inventory and when the
borrowing base is lower than the committed amount, this is used as maximum
amount available at the given time. Borrowers are subjected to periodic collateral
appraisals but, given the high security of the facility, the interest rate is lower than
cash flow revolvers and the number of covenants is lower 11. It typically lasts five
years.

9
This can be an enlargement of the existing debt instruments, issuance of new securities at HoldCo level, or as part of a
complete recapitalization of the financial structure.
10
The spread can be increased/decreased if tied to a performance-based grid that refers to the borrower’s credit rating.
11
Generally, the only covenant is a fixed charge coverage ratio of 1.0x, tested only when excess availability falls under
certain levels. Excess availability is defined as credit availability (borrowing base or committed availability) less
outstanding amounts under the facility.
Term Loan Facilities Term loans, defined leveraged loans if non-investment
grade, are loans with specified maturity and amortization through a defined
schedule. Typically first lien, they expect the borrower to comply with the financials’
requirements defined in the credit agreement. Unlike revolvers, once refunded it
cannot be reborrowed. A term loans, or TLA, or amortizing term loans, imply
substantial repayment during the life of the loan, thus minor risk and minor return.
TLAs are syndicated to commercial banks and finance companies generally together
with a revolver, with whom it is co-terminus. TLBs, or institutional term loans, are
larger in size and imply an amortization schedule that with a low nominal rate during
the loan life (on average seven years) and a bullet payment at maturity. It is generally
sold to institutional investors and it is the largest portion of term loans in the typical
LBO financing structure. Second lien term loans are generally of longer term and
larger size than TLAs and TLBs with no amortization during the life of the loan.
They are less secured then first lien debt (e.g., revolvers, TLAs, and TLBs), thus
more remunerative, but a number of covenants burden the borrower, even though less
binding. They are usually perceived from borrowers as a more flexible in structure
and sometimes less costly alternative to high yield bonds.
High Yield Bonds Non-investment grade securities with an average maturity
between seven and ten years, payment of semestral coupons (usually at a fixed rate,
in particular for LBO financing) and bullet at maturity, often tied to less
restrictive incurrence covenants. They can be senior unsecured, senior subordinated
or senior secured (with different grades of lien). Generally present in an LBO
financing structure due to the necessity to raise larger amounts of capitals than
available on the loan market and major flexibility during the life of the security than
other debt facilities. Usually sold to qualified institutional buyers, they can be
collocated on the market, requiring additional disclosure as to SEC regulation. During
robust credit markets, they can be issued with atypical “issuer-friendly” provisions12.
Bridge Loans Usually in the form of an unsecured term loan, only funded if the
take-out securities, especially bonds, cannot be issued and sold by the closing of the
transaction. This is used to give certainty of execution to the seller, but typically not
funded and, even if so, it is later substituted by take-out securities. It is a quite costly
form of financing due to additional fees for the borrower, and usually characterized
by a rising interest rate that increases by time until it touches the cap. Lead
arrangers, in order not to be excessively exposed to the buyer’s credit, tend to
syndicate the commitment to other institutions before the closing.
Mezzanine Debt Characterized by great flexibility in structuring terms, it is a form
of debt that stands between debt and equity and is tailored upon the needs of the
12
An example can be the Payment-in-Kind (PIK) toggle, that is to say that it can be refunded through additional notes
or in cash, allowing the borrower to preserve cash in difficult financial conditions. Typically, when the issuer chooses
the PIK payment, the coupon raises by 75 bps.
issuer and the investors. It represents an additional form of capital less expensive than
equity, typically prevalent in middle market transactions. Generally acquired by
dedicated funds, insurance companies, business development companies, and hedge
funds, it offers a mixed consideration (cash and PIK) and blended return.
Equity Contribution The remainder of the purchase price, sometimes offered by
multiple sponsors in a consortium of buyers that defines the “club deal”.
Rollover/contributed equity by current management and shareholders represents
between the 2% and 5% of the total equity contribution and is usually encouraged by
the sponsor. It furnishes a sort of cushion for lenders and bondholders.
6) Additional LBO Financing Information
Call Protection It is the feature of certain debt instrument that cannot be redeemed
during the life of the security without restrictions. This protection can prohibit the
voluntary prepayment or require a “call premium”. Call protection periods are
standard for high yield bonds: at four years for those with a seven/eight year maturity,
five for ten year maturities; since then fixed premiums must be charged (to read a
standard call schedule, see Appendix C).
Covenants They are contractual clauses that protect the lender from a
borrower’s deterioration in credit rating. Failure to meet the requirements may trigger
an event of default. They can be affirmative, negative, or financial. Bank debt is
typically characterized by maintenance covenants (tested on a quarterly basis) while
bonds are tied to incurrence covenants. Details on typical covenants can be found in
Appendix D.
Determining Financial Structure This is based on a thorough analysis of the
target’s intrinsic value (akin to DCF analysis) and on the market’s conditions (akin to
trading comps and transactions comps). It is based on a balance between the higher
leverage preferences from the sponsor and the leverage aversion of the lenders and
bondholders. This balancing is highly correlated to the business sector of the target
(cyclical industries require lower leverage) and the current multiples.
APPENDIX A (How LBOs Generate Returns)
APPENDIX B (How Leverage Is Used to Enhance Returns)

APPENDIX C (Standard Bond Call Schedule)

APPENDIX D (Bank Debt and Bonds Covenants)